I see a variant of this discussion come up a lot on social media and forums. Many have not heard of EMH or even index funds.
The discussion starts with, “should I invest in XYZ mutual fund? – the performance has been great lately”. Then someone else chimes in and recommends their mutual fund that has done great lately. Someone then states that they would gladly pay the management fee of 2% because the fund returned 23% last year.
It doesn’t get better from there.
- Why Does All Active Management Suck?
- The Efficient Market Hypothesis and Index Funds
- This is just the tip of the investment iceberg
- Academic articles
- Popular books why passive beats active management
- Does Buffett, Graham, and Markowitz recommend index funds?
- Professional studies showing why active management is a loser’s game
- The largest funds in existence are low-cost index funds
I take my knowledge for granted. The experience I have accumulated over the past 15 years. I cringe when I see someone ask about a hot new mutual fund that has had an excellent performance last year. I shouldn’t cringe, though. I should explain to them why the hot mutual fund may not be so hot.
This is what I recently did. Or I tried to anyway.
Below is the response I gave a user on Reddit, who asked to back up my claim as to why buying individual stocks was a loser’s game. “What were my sources?” he asked.
To put it bluntly, I was incredulous that anyone could ask such a question nowadays. I was utterly blown away. I thought: “how the hell could he be in the investing forum commenting with such confidence on a host of issues related to investing and ask that kind of question?” I felt like I was a mountain guide standing on top of a mountain looking down on the foot of the mountain, with my job being to explain the entire route to the top. This was an impossible task to do in 10000 characters (Reddit’s max per post).
I started anyway, and this is what it looked like.
Here are my sources – Well, a few anyway. It’s a pretty big mountain.
The Efficient Market Hypothesis and Index Funds
In 1965 Eugene Fama described the Efficient Market Hypothesis (EMH), showing why stocks were priced reasonably with all available information already incorporated into them. Fama is a Nobel Prize winner. He explained, as there is no new information to be had on the market, you do not have an edge over anyone else. This means you cannot hope to beat anyone else.
Source: Eugene Fama – The Behavior of Stock-Market Prices (1965)
In 1975 Charles Ellis published the famed article “The Loser’s Game” in Financial Analysts Journal. This became the successful book “Winning the Loser’s Game”. In this book, he showed how investing is like playing tennis. You need to avoid making mistakes to be successful. He also explained why money managers consistently underperform the market. Average investors (THAT’S US!) cannot hope to be better than professionals.
Source: Charles Ellis – Winning The Loser’s Game
In 1975 Paul Samuelsen urged in an article for someone to build an index fund because investors cannot select superior fund managers. Paul Samuelson is a Nobel Prize winner and maybe the most influential economist of the 20th century.
Source: Paul A. Samuelson, “Challenge to Judgment,” The Journal of Portfolio Management, Summer 1975, 18.
In 1975-1976 John Bogle, the supreme hero of the investing world, launched the first index fund via Vanguard, available to ordinary investors. The basis for that was his Ph.D. thesis showing that fees were the ultimate determinant of fund performance. Not manager skill. His book from 1999, Common Sense on Mutual Funds: New Imperatives for the Intelligent Investor, shows just how few mutual funds beat the market (not many). The managers of these funds are professional, well connected with the massive amount of resources at their disposal, yet they cannot beat the market. If they can’t beat the market, what makes the average investor (THAT’S US!) think that we can do that by looking at the Facebook ticker once in a while or even their financials?
John Bogle’s book should be obligatory reading for anyone thinking about investing.
Source 1: _Common Sense on Mutual Funds: New Imperatives for the Intelligent Investor
_Source 2: The Little Book of Common Sense Investing: The Only Way to Guarantee Your Fair Share of Stock Market Returns, 10th Anniversary Edition.
This is just the tip of the investment iceberg
This is just the tip of an enormous iceberg. The iceberg contains evidence showing that a portfolio of low cost diversified index funds beats out active management. I know of no study that shows that active management consistently beat the market. Why? Because if someone somehow managed to find an edge in the market and exploit it, it would be found out and exploited by others, and the gap would be closed. This is what the EMH described.
The underperformance of mutual funds (futility of stock selection)
- Michael C. Jensen, “The Performance of Mutual Funds in the Period 1945–64,” The Journal of Finance 23, No. 2 (May 1968): 389–416.
- Wharton School of Finance and Commerce, A Study of Mutual Funds, Reports of the Committee on Interstate and Foreign Commerce, 87th Congress, House Report 2274, 1962; and Jensen,
Michael C. Jensen, “Random Walks and Technical Theories: Some Additional Evidence,” Journal of Finance, May 1970, 469–482.
Popular books why passive beats active management
_Rick Ferri – The Power of Passive Investing: More Wealth with Less Work
_This is easily one of the best books on investing. Ferri cites dozens of academic and professional studies showing why active management and individual stock selection is a loser’s game and will underperform the market in most cases. This is a fantastic book.
Burton Malkiel – Random Walk Down Wall Street: A Time-Tested Strategy for Successful Investing (Eleventh Edition).
Malkiel is also showing us why no one can predict the market, and the best strategy is a well-diversified low-cost portfolio consisting of index funds. This is a classic.
William Bernstein: The Four Pillars of Investing: Lessons for Building a Winning Portfolio
_Jason Zweig: Your Money and Your Brain: How the New Science of Neuroeconomics Can Help Make You Rich
_Zweig is showing why everyone, from hedge fund managers to individual investors, all are prone to making the same mistakes.
_Ben Carlson: A Wealth of Common Sense: Why Simplicity Trumps Complexity in Any Investment Plan.
_Also, citing tons of studies why you should not be investing in individual stocks.
_Taylor Larimore: The Bogleheads’ Guide to Investing.
_More of the same, showing study after study why indexing beats out active management.
_David Swensen – Unconventional Success: A Fundamental Approach to Personal Investment._David Swensen is the CIO of the Yale Endowment Fund. Also, he shows why average investors (THAT’S US!) should invest in low-cost index funds and why exposing yourself to outsized risks by investing in individual stocks is a fool’s errand.
Does Buffett, Graham, and Markowitz recommend index funds?
Warren Buffett recommends that for the average investor (THAT’S US!) a split of 90% in a low cost S&P500 index fund and 10% in short-term government bond fund would be the best solution.” Put 10% of the cash in short-term government bonds and 90% in a very low-cost S&P 500 _index fund. (I suggest Vanguard.) ”
_Source: 2013 Letter to shareholders http://www.berkshirehathaway.com/letters/letters.html
The father of investing, Warren Buffett’s mentor, Benjamin Graham, also recommended low-cost index funds as he saw that no outsized gains were to be had. In an interview late in his life, he doubted the ability of money managers to create alpha. Graham was the granddaddy of how to find an edge in the markets. Graham authored the bible of investing, the book The Intelligent Investor.
I haven’t touched upon Harry Markowitz. He recommends investing in low-cost index funds and has stated he splits his portfolio 50/50 into equities and bonds. Harry Markowitz is a Nobel Prize winner and author of a little ol’ paper called “Portfolio Selection” (1952).
Professional studies showing why active management is a loser’s game
The yearly SPIVA report (S&P Indexes Versus Active) shows that over 15 years, only 8% of large-cap actively managed funds beat the S&P 500. This means if you had your money in Vanguards S&P fund VFIAX with an expense ratio of 0.04%, you would have beaten 92% of ALL actively large-cap fund managers in the USA. The under-performance INCREASES the farther out you measure it making under-performance a certainty after 40 years. See Ferri and Bogle. For all actively managed funds, this number is more forgiving over 15 years. Here 16.26% managed to outperform their indexes. This means holding a passive index fund would have beaten ALL active money managers 83.74% of the time. If most professionals can’t do it, what makes you unique?
The DALBAR studies showing each year just how bad individual investors are at investing. They show that average investors (THAT’S US!) underperform the market by 2-5% each year.
Source: Search for DALBAR Studies or http://realinvestmentadvice.com/dalbar-2017-investors-suck-at-investing-tips-for-advisors/
Here’s Charles Ellis to round it off:
“Active managers aren’t failing to beat the market because they are not informed, skillful, expert, and diligent. Quite the opposite; they can’t outperform the expert consensus of the other active managers after fees and costs with any consistency over time because so many competitors are so skillful, informed, hardworking, and so well-armed with information and technology.”
Source: “Portfolio Operations,” Financial Analysts Journal, September–October 1971, 36–46.
The largest funds in existence are low-cost index funds
- Vanguard Total Stock Market (VTSAX), AUM: $657billion
- Vanguard 500 Index Fund (VFIAX), AUM: $383billion
- Vanguard Institutional Index Mutual Fund (VINIX), AUM: $233billion
Can that many people be wrong? Can they be that stupid for not reaching for the 16.26% percent of funds that outperformed the index funds over the past 15 years?
Climbing the mountain of investing knowledge is a steep climb. I tried making it easier by presenting books and articles that hopefully will make investing easier.
One of the core tenets of investing is the efficient market hypothesis. Understand that, and you will change the way you view not only investing but the world.
Hey, why don’t you sign up for our newsletter to get more great information on investing every week? We promise you that you WILL become a better investor and get more money!